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INCOME FROM A BUSINESS OR EMPLOYMENT?

Many people try to change their status from "employee" to that of an "independent contractor", because they have been told they may be able to reduce their taxes as a result.  In most cases, however, the nature and manner of the work precludes an employee from claiming to be an independent contractor, as their work fails to meet the tests developed over time by the courts to determine a particular person's status under the Income Tax Act.

From a tax perspective, the distinction between employee and independent contractor does favor income as a contractor rather than an employee.  Even though the rates of tax are the same for both employees and independent contractors when the income is received by the individual, very few deductions (expenses) are available to offset the income of an individual who earns employment income, but an independent contractor has virtually the full range of business deductions allowed under the Income Tax Act in ascertaining the profit of the business.  The general rule is (there are always exceptions), as long as the expense was incurred for the purpose of producing income from the business, it is usually deductible.

For the employer, withholdings of income tax, Canada Pension Plan Contributions, and Employment Insurance premiums must be deducted from an employee's salary and accounted for.  No such withholdings are required when making payments to an independent contractor.  These items become the contractor's responsibility, relieving the burden from the employer.

It is not always easy to determine whether a person is an independent contractor, who receives income under contracts for the supply of goods and services, or an employee, who receives income under a contract of service.  To assist in this determination, the courts in Canada have developed several tests in order to characterize the "total relationship" between the parties, although no one test is determinative.  The following tests are the primary ones used by the courts and have become important in cases where the Canada Revenue Agency has challenged the status of persons who claim they are independent contractors.

The first test looks at the degree of control an employer has over the work to be performed.  In an employment relationship, the employer usually has a good deal of control by specifying not only the result to be accomplished but also the manner by which the work is to be done, whereas in a contractor setting it is more likely that the employer will specify the result to be accomplished, but the manner of achieving the result will be left to the contractor.  The "manner" in which the work is accomplished can include items such as hours of work, what equipment should be used, or what other personnel should be hired.

Second, the courts will examine whether the person, and the person's work, is an integral part of the employer's business, or whether it is just an accessory to the employer's business.  If it is an integral part, then the person will more likely be seen as an employee.

Third, when tools and equipment are required on the job site to complete the work, a person who provides and uses his or her own tools and equipment is more likely an independent contractor.

Fourth, if the person has the chance of making a profit and the risk of loss, the person is more likely an independent contractor.  Employees rarely, if ever, have a risk of loss during their employment.

Finally, if the person has been hired to achieve a specific result, rather than merely placing his or her services at the disposal of the employer for a period of time without reference to a specified result, then the person is more likely to be seen as an independent contractor.

If, upon a review of these aspects, it can be determined that the person is an independent contractor, the expenses which that person wishes to deduct from income must still meet the requirements for deductibility as already mentioned.  If the person has claimed independent contractor status but later fails to meet the requirements when challenged by the Canada Revenue Agency, there may be reassessed taxes, interest, and (possibly) penalties on the amounts claimed as deductions from income.

It must be remembered that the above discussion deals only with the income tax perspective and the primary tests used for determining contractor or employment status, and does not take into account other important considerations one should look at when examining the question of whether it is preferable to be an independent contractor or an employee, such as job security, benefits, etc.  It is highly recommended that a person seek professional advice regarding their particular circumstances and needs before attempting to make a change in their employment / contractor status.

By Tom Langford
October 27, 2004